Does Moving a 529 College Savings Plan into a Roth IRA Make Sense?

Does it make sense to move our $40,000 529 college savings plan
into a Roth IRA for our children who are both in college to shield the
money from our asset consideration? We have a gross income of about
$100,000 and no debt. They have some merit scholarships, but we have
not qualified for need on the FAFSA.
— Carolyn W.

Although a Roth IRA is ignored as an asset on the Free Application for
Federal Student Aid (FAFSA), there are several reasons why families should
not move 529 college savings plan funds into a Roth IRA.

Income Matters More Than Assets

The 529 college savings plan assets do not have a significant impact
on eligibility for need-based student financial aid.

Need analysis formulas are heavily weighted toward income, not
assets. Less than 4% of dependent students have any contribution from
parent assets in the calculation of the expected family contribution
(EFC). (Child assets are assessed at a much greater rate than parent
assets, but 529 college savings plans are treated as though they are
parent assets.) If a family has annual income in the six figures, the
income by itself is sufficient to prevent the family from qualifying
for need-based government grants even if they have no assets.

Consider also that the federal need analysis methodology has an asset
protection allowance based on the age of the older parent that
shelters a portion of reportable assets on the FAFSA. For most
parents of college-age children, this typically shelters about $50,000
in parent assets. Any remaining assets above the asset protection
allowance are assessed according to a bracketed scale with brackets
that range from 2.64% to 5.64%. So the worst-case impact is a $564
reduction in need-based aid for every $10,000 in 529 college savings
plan assets.

Distributions from Non-Reportable Assets Count as Income to the Beneficiary

A Roth IRA may have a significant impact on eligibility for need-based
student financial aid.

A Roth IRA is not reported as an asset on the FAFSA, but all
distributions from a Roth IRA — even a tax-free return of
contributions — are treated as income to the beneficiary on the
subsequent year’s FAFSA. (This is also true of other non-reportable
assets, such as 529 plans that are owned by someone other than the
student or parent, qualified retirement plans, life insurance policies
and annuities.) The income will be reported either as taxable income
as part of the adjusted gross income (AGI) or as untaxed income on the
FAFSA. Either way the income has the same impact on the student’s EFC.

This can have a severe negative impact on aid eligibility, much
more severe than the asset treatment of a 529 plan. Treating a
distribution as income to the beneficiary will reduce aid eligibility
by up to 50% of the amount of the distribution.

There are a few workarounds. One is to wait until the student’s senior
year in college to take a distribution. If the student won’t be going
to graduate school, there will be no subsequent year’s FAFSA to be
affected by the distribution. The student could also wait until after
graduation and use a tax-free return of contributions to pay down
their student loans. Finally, the student could use the Roth IRA for
the intended purpose, to save for retirement, and not take any
distributions. So long as there are no distributions from a Roth IRA,
the Roth IRA will not affect eligibility for need-based financial aid.

Taxpayers Cannot Directly Transfer Funds from a 529 Plan into a Roth IRA

The Internal Revenue Code does not permit a taxpayer to roll over a
529 college savings plan into a Roth IRA. Instead, one must take a
nonqualified distribution from the 529 plan and invest the cash in a
Roth IRA, subject to the applicable annual limits.

Taxpayers who take a nonqualified distribution from a 529 plan account
to fund a Roth IRA will not only have to pay ordinary income taxes on
the earnings portion of the distribution, but also a 10% tax
penalty. The tax liability usually outweighs any potential increase in
student aid from sheltering the funds as an asset.

If the taxpayer received a state income tax deduction or tax credit
based on their contributions to the state’s 529 college savings plan,
recapture rules may require repaying this tax benefit if the taxpayer
takes a nonqualified distribution from the 529 college savings plan.

Low Roth IRA Contribution Limits Affect Ability to Save for College

The Roth IRA contribution limits for 2012
are $5,000 for taxpayers under age 50 and $6,000 for taxpayers age 50
or older. The contribution limits are also capped at total taxable
compensation, whichever is lower.

If the 529 plan assets fall below these thresholds, they are not large
enough to have much of an impact on aid eligibility. To accumulate
significant sums in a Roth IRA requires several years worth of contributions.

Evaluate Impact with an EFC Estimator

Before playing asset-shifting games, use an EFC calculator
to evaluate the impact of sheltering the 529 college savings plan and
the impact of counting the distribution from a Roth IRA as income to
the beneficiary.